Cancellation of debt might let you off the hook as far as your creditor goes, but your responsibility to the IRS could very well remain. When a taxpayer owes a debt and the creditor releases the taxpayer from the obligation to pay it, the IRS considers the amount forgiven to be income for the taxpayer that is subject to tax. An estimated 5.5 million 1099-C forms have been sent out this year so taxpayers can report income from cancellation of indebtedness. Such income can be the result of written off credit card or loan debt, vehicle repossession, student loan forgiveness or mortgage debt relief from a loan modification, foreclosure or short sale.
Under the income-based federal student loan repayment program, a taxpayer is obligated to repay student loans based on the amount of his or her income. After a period of on-time payments (usually somewhere between 10 to 25 years), the remaining balance is forgiven. However, taxpayers are not free and clear yet: they still owe tax on the amount forgiven. This can come as a shock to someone who had qualified for reduced loan payments based on his or her amount of income. In addition, there is no exclusion for student loan debt canceled due to disability, so a person who is unable to work because of a physical ailment might still owe tax on a forgiven student loan.
Lenders will send a 1099-C to anyone for whom cancellation of indebtedness income has been reported, and they will also send a copy to the IRS. It is up to the taxpayer to prove why the amount should be excluded from gross income on the tax return, using Form 982. The most common reasons to exclude cancellation of indebtedness income are bankruptcy, a tax break under the Mortgage Debt Forgiveness Tax Relief Act or meeting the IRS definition of insolvency.
If the debt was forgiven in a bankruptcy decree, the taxpayer simply enters the amount discharged on Form 982, but student loans are rarely dischargeable in bankruptcy proceedings. If the cancellation of indebtedness income is a result of a principal reduction, loan modification, foreclosure, or short sale of the taxpayer’s principal residence, the taxpayer can get relief from the Mortgage Debt Forgiveness Tax Relief Act, which excludes up to $2 million from income. The American Taxpayer Relief Act, signed January 1, 2013, extended this provision until the end of 2013.
The tricky case involves meeting the IRS definition of insolvency. Taxpayers can exclude canceled debt from gross income to the extent that they were insolvent immediately before the cancellation. In other words, a taxpayer must calculate his total amount of liabilities and the fair market value of all his assets immediately before the cancellation of the debt. The amount by which the liabilities exceed the assets can be excluded from gross income, reducing or eliminating the amount on the 1099-C. Of course, these calculations can present all sorts of complications. What about business indebtedness? Or what about a divorcing couple’s joint debt? How does a taxpayer calculate the fair market value of his assets as of a specific day in the past?
The IRS provides some guidance for such questions in Publication 4681: Canceled Debts, Foreclosures, Repossessions and Abandonments, but the use of a tax professional is necessary. A CPA can help taxpayers determine the extent to which they were insolvent and explore potential issues with statutes of limitations that could possibly relieve the taxpayer of the tax liability altogether.
You may think you are safe if you haven’t received a 1099-C, but you are not necessarily off the hook. The IRS and state tax authorities will still hold you liable for cancellation of indebtedness income. A tax professional can help you navigate this extremely complex arena and potentially save you thousands of dollars.